CHAPTER 15 – PORTFOLIO AND MARKET ANALYSIS

Question 1

The following are sample allocation applications that are based on the age of a customer:
▪ A 25-year-old may want 25% of his portfolio allocated to fixed-income investments, with 75% allocated to equity securities
▪ A 45-year-old may want 45% of his portfolio allocated to fixed-income investments, with 55% allocated to equity securities
▪ An 80-year-old may want 80% of his portfolio allocated to fixed-income investments, with 20% allocated to equity securities

Answer 1

Bonds as Part of an Asset Allocation

Keep in mind, these percentages may need to be adjusted based on the financial profile and risk
tolerance of an individual customer.

Question 2

An RR’s clients are a husband and wife who are both in their 20s and have jobs that pay well. If they’re considering several asset allocations to create a long-term retirement savings portfolio, what’s an appropriate investment mix?

Choice A - An asset allocation of 80% stock and 20% bonds
Choice B - An asset allocation of 100% stock

Answer 2

Investment Selection 80% stock and 20% bonds placed into IRAs

Rationale To accumulate the assets that they’ll need at retirement, the couple should include a significant allocation of common stocks in their portfolio. Placement of the investments into an IRA will serve to defer any taxes due. Although a portfolio that’s predominately allocated to bonds will be safer, it’s unlikely to produce the required long-term returns.

Question 3

During an initial interview with a successful 45-year-old doctor who has her own practice, she makes it clear to her RR that she’s disturbed by the thought of taking risks with her money, but realizes that the stock market provides the best long-term returns. What should the RR recommend for this customer?

• Choice A - A portfolio consisting of 60% equity and 40% fixed-income
• Choice B - A portfolio primarily consisting of municipal bonds with a small to
  moderate (20 to 25%) allocation of equities

Answer 3

Investment Selection A mix that’s weighted heavily toward municipal bonds or municipal bond funds and a small allocation of individual equity securities and/or equity funds.

Rationale Based on the asset allocation approximation rule, the recommended portfolio may appear to hold too little equity. However, in this case, the increased bond allocation is appropriate given the customer’s risk aversion.

A customer’s ability to tolerate risk is not based solely on her financial resources, but also on her values and attitudes. Two customers who have the same financial resources may perceive risk differently. An RR should pay careful attention to what investors say about their tolerance for risk since an investment recommendation that goes against a client’s expressed wishes is never suitable.

Question 4

The client is a New York advertising agency executive who is interested in
making a mutual fund investment. The client is 30-years-old, single, has an annual salary of $250,000, and recently received a sizable bonus to be used as the down payment to purchase a home within the next year. What’s the most appropriate recommendation?

• Choice A - An asset allocation of 70% equity and 30% debt
• Choice B - An asset allocation of 100% money-market funds and/or short-term bonds

Answer 4

Investment Selection A portfolio of money-market funds and/or short-term bonds

Rationale It may initially seem as though this client is the perfect candidate for a growth portfolio; however, his investment time horizon is not long enough.

Before designing an investment program for a customer, an RR must determine the investor’s time horizon (i.e., the amount of time that a client has available to achieve his financial goals). Generally, the longer an investor’s time horizon, the more volatility (fluctuation) the portfolio can tolerate. Investors with short time horizons usually require more stable, conservative investments since they will need their money sooner. Based on this client’s short time horizon, equity investments are unsuitable. The client will need liquid assets to purchase his home and cannot afford fluctuations in value; therefore, a money-market or short- term bond fund is the most suitable.

Question 5

A 35-year-old small business owner, who is single and appears to be doing well financially, informs an RR that he wants to day-trade. Fearing identity theft, the client refuses to provide the RR with background information beyond what’s required under AML rules (e.g., name, Social Security number, date of birth). What should the RR recommend for this client?

• Choice A - A collection of small capitalization equities and some long options
• Choice B - Nothing

Answer 5

Investment Selection: Nothing

Rationale Some clients may be reluctant to disclose their complete financial information. If a client refuses to provide certain information, an RR may not make assumptions about the client’s finances.

An RR may only make recommendations that are based on the information that has been disclosed by the client. In some cases, a firm may decide not to open an account due to a client’s unwillingness to provide sufficient background information

Question 6

A high-income, high-net-worth investor is seeking income and safety of principal. What’s the appropriate allocation recommendation for this customer?
- Choice A - A mix of U.S. Treasuries and high-grade corporate bonds
- Choice B - A mix of investment-grade municipal bonds

Answer 6

Investment Selection: Investment-grade municipal bonds

Rationale Safety of principal refers to a customer’s desire to be able to preserve or retain the initial amount of her investment over its life. Many bonds offer this benefit to investors. The higher the rating of the debt instrument, the greater the likelihood that investors will achieve the safety of principal that they desire. Investment-grade municipal bonds offer safety of principal and also offer tax-exempt income to investors who are in a high tax bracket. In this case, although the Treasury securities and corporate bonds will provide income, the income is federally taxable. Remember, since investors who have significant taxable income will typically have a higher marginal rate of taxation, they’re good candidates for tax-free bonds.

Question 7

An RR’s client is an elderly customer who is seeking preservation of his capital. What investment should an RR recommend to this customer?
- Choice A - U.S. Treasury bonds
- Choice B - U.S. Treasury bills

Answer 7

Investment Selection: U.S. Treasury bills

Rationale Investors who are concerned about the potential loss of their capital will invest in securities that provide safety. Although they want to achieve a return on their investment, these investors don’t want to put their principal at risk. Although T-bonds are not subject to default risk, they do expose customers to interest-rate risk. On the other hand, T-bills protect clients against both default risk and interest-rate risk. Older clients with a preservation of capital objective often invest in short-term instruments, such as U.S. government T-bills, insured certificates of deposit, or money-market funds.

Question 8

An RR’s client is a recent college graduate who has just landed his first full-time job and has recently moved out of his parents’ home. If the investor wants to allocate 10% of his salary to stock market investments, what’s an appropriate recommendation?
- Choice A - A variable annuity
- Choice B - A work-sponsored retirement plan

Answer 8

Investment Selection: Prior to investing the client’s assets, the appropriate step is to have the client investigate whether his employer offers a retirement plan, such as a 401(k) plan.

Rationale Employer-sponsored retirement plans typically grow on a tax-deferred basis and are often the first choice to consider when making an investment. Generally, these plans permit pre-tax investments (which reduce current taxable income) and normally offer a wide range of low-cost investment choices.

Question 9

The client is a retired school teacher who is seeking current income and a portfolio that provides some inflation protection. If she’s willing to accept a moderate level of risk, what should an RR recommend?
- Choice A - A collection of high-grade convertible corporate bonds
- Choice B - A high-yield bond fund

Answer 9

Investment Selection: High-grade convertible corporate bonds

Rationale Investors with a primary investment goal of current income want investments that produce a steady, reliable stream of cash. These investors typically need this income in order to defray daily living expenses, especially during retirement years. Some examples of income investments include most bonds, preferred stocks, and fixed annuities. Often, the downside to income investments is that they produce little, if any, growth in principal (the original amount invested). Over time, this may present a problem due to the fact that inflation erodes the purchasing power of the income.

Investment-grade (highly rated) convertible corporate bonds offer investors both the safety of income and the potential for appreciation if the underlying equity increases in value. Although U.S. Treasury securities are safer, they don’t offer the equity upside potential of a convertible issue. If clients demand an even greater degree of safety, TIPS are an appropriate choice.

Question 10

An RR’s client has been using a 529 plan to save for her child’s college education and her child will be attending college in a few years. What asset allocation should an RR recommend?
- Choice A - A mix of 80% equities and 20% fixed-income securities
- Choice B - A mix of 20% equities and 80% fixed-income securities

Answer 10

Investment Selection: 20% equity securities and 80% fixed-income securities

Rationale Although the student is young, she will soon need to access the funds for college. As a child approaches college age, a suitable investment strategy is to move from growth-oriented securities (e.g., equities) to income-oriented securities (e.g., bonds and money-market funds). Once a child begins to attend college, most of the funds should be invested in money-market funds or other types of short- term investments that offer liquidity and limited capital risk. In this case, since there are a few years remaining for the assets to grow, a minimal percentage of the account should be invested in equities.

Question 11

A registered representative’s customers are a husband and wife who are in their early 70s and are retired. They live on a small pension from the post office and also collect Social Security benefits. If the couple has assets of $355,000 to invest and they’re in the lowest tax bracket, what portfolio allocations are most suitable?
- Choice A - A mix of 25% domestic equities, 60% bonds, 10% cash, 5% international equities
- Choice B - A mix of 75% high-grade municipal bonds and 25% equities

Answer 11

Investment Selection: 25% domestic equities, 60% bonds, 10% cash, 5% international equities

Rationale Considering the customers’ ages and limited incomes, investing a greater portion of their assets in bonds will provide additional income, while the assets invested in equities will provide the potential for growth. As explained previously, one approach that’s used by many professionals is to subtract a client’s age from 100 to determine the percentage of assets that should be invested in equities. The general assumption is that as clients get older, they have less risk tolerance and, therefore, less money should be invested in equities. Only a small percentage of a client’s assets should be allocated to the international marketplace. Remember, clients who are in the lowest tax bracket are generally not good candidates for municipal investments.

Question 12

A customer in his early 50s has recently received a sizable bonus and has an investment objective of growth. The customer has an existing large portfolio of equities and fixed- income securities. Now the customer is seeking additional diversification into real estate, but wants access to his funds if an emergency arises. What should be recommended to this customer?
- Choice A - A REIT
- Choice B - A new construction DPP

Answer 12

Investment Selection: A REIT

Rationale Since the customer already has a large, existing portfolio of equity and fixed-income investments, some exposure to alternative asset classes is appropriate. Both DPPs and REITs provide this type of diversification. However, it’s important to notice that the customer requires liquidity. When comparing REITs to DPPs, most REITs are exchange-traded and provide liquidity, while DPPs are not exchange-listed and often have multi-year holding periods.

Question 13

A newly married couple in their early 20s is interested in investing a portion of the money they received as wedding gifts. The couple has very little savings and virtually no investment experience. If they have just purchased a new home and are eager to begin making money in the stock market, what’s the appropriate recommendation?
- Choice A - A mix of index mutual funds and corporate bonds
- Choice B - Short-term bonds or money-market securities and a small allocation of equity

Answer 13

Investment Selection: Short-term bonds or money-market securities and a small allocation of equity

Rationale As a general rule, most investors should have a cash reserve equal to at least three months’ living expenses. In certain circumstances, such as when a client’s income is unpredictable, it may be wise to maintain a larger cash reserve. These capital reserves should be kept in a safe, liquid investment such as a money-market fund. Although this couple is ready and willing to invest in the stock market, until they establish sufficient cash reserves, only a small portion of their assets should be allocated to equities.

Question 14

An RR’s customer is a biotech engineer who believes that biotechnology will be a leading industry in the 21st century. He wants some exposure to this area of investing that offers high-risk with the potential for high-reward and is seeking to maximize his returns by utilizing margin. What investment should be recommended to this customer?
- Choice A - A biotechnology sector ETF
- Choice B - A biotechnology mutual fund

Answer 14

Investment Selection: A biotechnology sector ETF

Rationale Both the biotechnology ETF and the biotechnology mutual fund provide exposure to this market segment. A sector ETF concentrates its investments in a given industry, such as mining, biotechnology, or computer technology. While these funds are certainly more risky than other diversified offerings, they provide exposure to a given industry for any investors who seek it. The key to this question is that the customer intends to use margin to maximize his returns. Remember, ETFs are marginable, but mutual funds are not.

Question 15

The customer is an accredited investor who consistently invests in high-risk ventures. He’s a seasoned stock market investor who enjoys trading both options and leveraged products. The customer is also the custodian for his 6-year-old niece’s UGMA account. What investment(s) should be recommended for the UGMA account?
- Choice A - Hedge funds, since these products offer the potential for significant returns
- Choice B - A broad collection of equity securities

Answer 15

Investment Selection: A broad-based portfolio of high-quality stock funds or good quality individual stocks

Rationale In some cases, assets are being invested for the benefit of a third party such as a child or infirmed relative. In these cases, the RR must examine the profile and objective of the beneficiary, not the person who is making the ultimate investment decisions. In this case, a high-quality equity portfolio is a suitable recommendation for the niece’s account. Hedge funds are illiquid investments and are inappropriate for placement in a UGMA account.

Question 16

This method of analysis is used by investors who are concerned with a company’s future earnings potential. The investors are seeking companies with rapidly growing earnings in the hope that this growth will continue. Growth investors believe that if the company’s earnings are outperforming the market, the stock’s price will continue to increase. Also, as long as the company controls its costs and increases sales, the value of the business will increase and the stock price will grow along with future earnings.
G
rowth investors usually purchase stocks that have high _ ratios, a high level of retained earnings, and low dividend payout ratios. Remember, growth companies tend to retain most of their earnings to finance expansion of operations rather than paying dividends to shareholders.

Answer 16

This method of analysis is used by investors who are concerned with a company’s future earnings potential. The investors are seeking companies with rapidly growing earnings in the hope that this growth will continue. Growth investors believe that if the company’s earnings are outperforming the market, the stock’s price will continue to increase. Also, as long as the company controls its costs and increases sales, the value of the business will increase and the stock price will grow along with future earnings.

Growth investors usually purchase stocks that have high Price-to-Earnings (P/E) ratios, a high level of retained earnings, and low dividend payout ratios. Remember, growth companies tend to retain most of their earnings to finance expansion of operations rather than paying dividends to shareholders.

Growth Analysis

Question 17

The value analysis method is used by investors (or funds) that are interested in stocks of companies that are intrinsically undervalued or trading at a discount to their book value. If the market is efficient and the issuing companies continue to generate profits, these stocks are attractive to long-term investors since their depressed prices make them a good value. Value stocks are characterized by a low P/E ratio, a history of profits, a high dividend yield, and a low market-to-book ratio.

Answer 17

Value investors are most concerned with the fundamental value of businesses as opposed to their current share price and believe that companies that are out of favor and underperforming may be overlooked. Many of these investors have very long-term time horizons and seek out companies that are undergoing a fundamental change such as a restructuring or shift in leadership.

Value Analysis

Question 18

The market-to-book ratio is calculated by

Answer 18

current closing price of the stock
÷
most current quarter’s book value per share

A low ratio (less than 1) could indicate that the stock is undervalued (i.e. a bad investment), and a higher ratio (greater than 1) could mean the stock is overvalued (i.e. it has performed well

Question 19

When following the _ analysis approach, a broad analysis of the economy is conducted first and then specific industries are identified that seem to benefit from the anticipated future economic conditions. Ultimately, particular companies are chosen from within those industries.

Answer 19

the top-down analysis approach

Question 20

The _ analysis focuses on fundamental analysis and the evaluation of companies based on a number of factors. The goal is to find stable companies that have a history of profits and to determine whether a company is undervalued relative to its peers. The analysis will also consider the economic climate to further validate the investment decision.

Answer 20

The bottom-up analysis

Question 21

_ investors often move rapidly from one sector of the market to another essentially in an effort to chase money flows. For example, if gold stocks are in favor, they will overbuy in that area; however, if auto stocks are subsequently moving higher, they will change focus rapidly. Many of these investors use sector specific ETFs to accomplish this rapid movement from one sector to another.

Answer 21

Momentum investors

Question 22

The _ approach basically concedes that most investors don’t outperform the market. The goal of indexing investors is to find the least expensive and most tax-efficient products that reconcile with their objectives. These investors often choose to go it alone since they believe registered representatives or financial advisers lack the knowledge to beat the market. Investment choices may include index funds and ETFs since both of these products offer a low-cost and tax-efficient way to gain broad exposure to the market.

Answer 22

The index approach

Question 23

One of the basic assumptions of the _ _ Theory is that investors are risk-averse.
Essentially, investors prefer the lowest risk possible to obtain a given level of return. Or, put another
way, investors want the highest return possible given a specific level of risk

Answer 23

Modern Portfolio Theory

Question 24

An optimal portfolio is

Answer 24

one that provides the greatest return for a given amount of risk

Question 25

MPT has found that the key to optimal portfolios is the degree of correlation between asset
classes. Finding asset classes that don’t show a high degree of positive correlation produce the best results. Ideally, investors would like assets that showed strong negative correlations, but this desire is not always realistic. Although most financial assets show some degree of positive correlation, excellent results may still be produced with investments that show a modest lack of correlation.

Question 26

Investment Horizon

20 to 30 years until retirement

What allocation?

Answer 26

80% - Stock
15% - Bonds
5% - Cash

Question 27

Investment Horizon

10 to 20 years until retirement

What allocation?

Answer 27

60% - Stock
30% - Bonds
10% - Cash

Question 28

Investment Horizon

Five years until retirement

What allocation?

Answer 28

40% - Stock
40% - Bonds
20% - Cash

Question 29

Investment Horizon
At retirement age and beyond

What allocation?

Answer 29

30% or less - Stocks
40 to 80% - Bonds
20% or more - Cash

Question 30

_ and _ monitor the performance of a group of securities. Some are intended to reflect
the entire market and are referred to as broad-based, while others measure only a market segment or particular industry and are referred to as narrow-based.

Answer 30

Indexes and averages

■ Dow Jones Industrial Average - consisting of 30 stocks
■ Dow Jones Transportation Average - consisting of 20 stocks
■ Dow Jones Utility Average - consisting of 15 stocks

Of the three Dow Jones Averages, the Dow Jones Industrial Average (DJIA) is the most commonly quoted. The DJIA contains 30 of the leading blue-chip companies that represent the backbone of industry in the U.S., such as Apple, Pfizer, and IBM.

Question 31

are the most widely quoted measurements of the stock market.
- consists of 65 stocks

Answer 31

The Dow Jones Averages

Question 32

The _ Composite Index consists of mainly NYSE stocks, but also some NYSE Mkt LLC (formerly AMEX) and Nasdaq stocks. This index gives a broader measure of the market as compared to the Dow Jones Averages. The _ Index consists of approximately:
■ 400 industrial stocks
■ 20 transportation stocks
■ 40 financial stocks
■ 40 utility stocks

Answer 32

The S&P 500 Composite Index

Question 33

The _ Index contains all of the common stocks that are listed on the New York Stock Exchange. As with the S&P 500 Index, this index is also divided into four sub-indexes for industrial, transportation, financial, and utility issues.

Answer 33

The NYSE Composite Index

Question 34

The _ Index consists of stocks that trade on the New York Stock Exchange, the NYSE Mkt LLC, and Nasdaq. The index represents the dollar value of all of the stocks and is considered the broadest of all indexes and averages.

Answer 34

The Wilshire Associates Equity Index

Question 35

The _ Index tracks the smallest 2,000 stocks in the Russell 3000 Index and is considered the best indicator of small capitalized companies.

Answer 35

The Russell 2000 Index

Other Indices Some of the other indices that are widely used include the Major Market Index which consists of 20 well-known highly capitalized stocks, the Nasdaq Composite Index which consists of all Nasdaq-listed securities, and the Nasdaq 100 which consists of 100 of the largest companies listed on Nasdaq. The Morgan Stanley Capital International Europe, Australasia, and Far East (MSCI EAFE) Index follows the equity performance of the developed markets, but excludes the U.S. and Canada. Lastly, the FTSE Index mostly follows the stocks of companies that trade on the London Stock Exchange. (The FTSE acronym is derived from its two parent companies the Financial Times and the London Stock Exchange.)

Question 36

_ attempts to describe how the market values (prices) investments and provides insights into the nature of risks

Answer 36

Capital Asset Pricing Model (CAPM).

Question 37

This risk, which is also referred to as market risk or systematic risk, is associated with the overall movement of the market. Since this risk is not able to be avoided through diversification, investors are rewarded for assuming it. The greater the _ risk, the greater the potential reward.

Answer 37

Non-Diversifiable Risk

Question 38

The amount of non-diversifiable risk associated with a particular portfolio or asset is measured
as beta (β). The value of beta describes the risk of a portfolio or asset as compared to the total market, which is measured as volatility. The total market is assigned a β value of 1; however, some
representation of the total market (usually the S&P 500 Index) is commonly employed.

Answer 38

For example, if Investment Z has a β of 1.5, this suggests that it’s 50% more
volatile than the market as a whole. Therefore, if the market rises by 10%,
Investment Z is expected to rise by 15% (10% x 1.5). Conversely, if the market
declines by 10%, Investment Z is expected to decline by 15% (10% x 1.5).

An investment with a β of less than 1 is not as volatile as the total market and is expected to fall less in
declining markets than the average security, but also rise less in bull markets. When beta is calculated
for an entire portfolio, the weighted average of the betas of the component parts (securities) is used.

Question 39

While a stock’s beta measures its performance related to the overall market, alpha measures
the portion of a stock’s return that’s achieved independent of the market. Alpha is influenced by
factors that are unique to the company and its industry group.

As a risk-adjusted return, alpha represents the difference between an asset’s expected return (as
implied by beta) and its actual return. If a security’s actual return is higher than its beta, the security
has a positive alpha; however, if the return is lower, it has a negative alpha.

Answer 39

Alpha

Question 40

The _ is the online newspaper of the municipal industry that contains
news that’s pertinent to both the municipal market and the financial community in general. It also
contains announcements such as notices of sale, call notices, and a new issue calendar.

The _ includes a variety of statistics that relate to the municipal bond market.

Answer 40

The Bond Buyer

Question 41

The 30-day _ is compiled on a daily basis (with weekly average
shown) by adding together the total dollar value of all municipal securities being underwritten on a
competitive and negotiated basis which are expected to reach the market over the next 30 days.
Issues that are due to mature in 13 months or more are included in the totals. The _
gives an indication of the supply side of the market.

Answer 41

Visible Supply

Question 42

The _ ratio is compiled on a weekly basis at the close of business on Friday. The ratio represents the dollar amount of bonds that were sold by underwriting syndicates over the week as a percentage of the amount of bonds that were issued that week. To be included, an offering must be for $1 million or more. The _ ratio gives an indication of the demand side of the market.

Answer 42

The Bond Buyer Placement Ratio

Question 43

The Bond Buyer compiles information regarding different indexes that are
widely watched in the municipal bond industry. These indexes provide an indication of the average
weekly yields for both general obligation and revenue bonds

Answer 43

Bond Buyer Indexes

Question 44

• The 20 Bond Index This index shows the average yield on 20 general obligation bonds with 20-year maturities and has an average rating that’s equivalent to Aa2 for Moody’s and AA for S&P.
• The 11 Bond Index This index shows the average yield on 11 of the 20 bonds that are in the 20 Bond Index and has an average rating that’s equivalent to Aal for Moody’s and AA+ for S&P.
• The Revenue Bond Index This index shows the average yield on 25 revenue bonds with 30-year maturities and has an average rating that’s equivalent to Al for Moody’s and A+ for S&P.

Answer 44

• Bond Buyer Municipal Bond Index This index represents the average of the prices of 40 recently issued and actively traded municipal bonds. The prices are calculated based on quotations that are obtained from municipal broker’s brokers. The index is published daily and the components of the index are adjusted twice per month.
• The SIFMA Index This index is a seven-day market index of Variable Rate Demand Obligations (VRDOS) with at least $10 million outstanding.
• The Municipal Market Data (MMD) Curve This is the yield curve of the highest-rated (AAA) municipal bonds and it’s published by Thomson Reuters.

Question 45

_ analysis involves the study of indexes, averages, theories, price trends, and charts in an
effort to predict the direction of both the overall market and specific stocks.

Answer 45

Technical Analysis

Technical analysts tend to ignore the fundamental approach and assume that markets are efficient and all information (both public and private) has already been incorporated in a security’s price. These analysts consider the past history of both securities and the markets to formulate their opinions

Technical analysts seek to identify market trends as early as possible and they advise their clients
regarding which investments will likely profit from the trend until there’s a reversal. To do this,
technical analysts follow the markets, individual securities, and an assortment of market data.

Question 46

A _ is a solid line that traces the lows of a stock as it moves in an upward direction, or the
highs of a stock as it moves in a downward direction. Once established, the price movement of a stock will usually follow the _.

Answer 46

trendline

Question 47

_ _ refers to the strategy of attempting to profit by buying some securities while at the same time selling short other securities.

Answer 47

market momentum

Question 48

_ interest refers to the amount of a company’s common stock that’s
been sold short, but has not yet been covered (closed out).

Answer 48

Short Interest

Although it may appear that an increase in short interest from one month to another is a bearish
indicator, those who follow the short interest theory normally consider rising or large short interest to
be a bullish indicator. According to the short interest theory, short sellers must eventually cover their
short sales and, as they purchase the stock, it will cause the market price to increase. Other short sellers, fearing future increases in the stock’s price, will cover their short sales and create additional upward pressure on the stock (commonly referred to as a short squeeze)

Question 49

_ ratio is a technical market indicator that’s found by dividing the volume of all put transactions by the volume of all call transactions on a daily basis. Technical analysts view the _ ratio as a contrarian indicator. Although a high ratio indicates that the mood of investors is bearish, from an analyst’s point of view it reflects an oversold market and a higher probability that the market will reverse course and turn bullish. The opposite is true for a low _ ratio, which is viewed as a bearish indicator

Answer 49

put/call ratio

Question 50

The _ theory focuses on the trading activity of small investors. Small
public investors are commonly referred to as odd-lotters due to their purchases and sales typically being in amounts that are less than 100 shares (i.e., odd-lots).

The theory suggests that small investors are usually incorrect in their market timing. In other words,
they purchase when the market is at its highest and sell when the market is at its lowest. Statistics are
kept that track odd-lot purchase and sell orders and are published on a daily basis.

Answer 50

odd-lot theory

Technical analysts often advise their clients to buy when odd-lot sell orders increase relative to odd-lot
buy orders. A sell recommendation will be issued by analysts when odd-lot buy orders increase relative
to odd-lot sell orders. Basically, technical analysts advise investors to do the opposite of whatever
action is taken by small public investors

Question 51

_ figures measure the number of stocks that have
increased compared to the number that have decreased during a trading session or other period.
This data, which is intended to show the direction of the market as well as the breadth of a market
movement, is published daily.

Answer 51

Advance-decline figures

According to this theory, it’s a bullish indicator if there’s a positive advance-decline figure (i.e., more
advancing issues than declining issues). However, it’s considered bearish if the market averages
(e.g., the Dow Jones Industrial Average) are up, but the advance-decline figures are negative.

Question 52

According to this theory, a major trend is confirmed only when both the Dow Jones Industrial Average
and Dow Jones Transportation Average reach a new high or new low. Without this confirmation, the
belief is that the market will drift back to its previous trading pattern.

Answer 52

The Dow Theory

Question 53

Over time, a stock tends to trade within a certain price range. In some cases, there’s an increase to a particular price level at which heavy selling pressure is encountered. This is referred to as an area of resistance. At this point, prices are too expensive and it causes buying to cease. For this reason, analysts describe the market as being overbought.

Answer 53

In other cases, there’s a decline to a particular price level that causes investors to purchase at the
attractive lower price. This buying stops the price decline and is referred to as an area of support.
Ultimately, prices become so enticing that selling stops and buying begins. For this reason, analysts
describe the market as being oversold.

When a stock is trading between what’s been identified as its support and resistance levels, it’s
considered to be in the consolidation phase.

Question 54

A _ occurs when the stock’s price either increases above a resistance level or
declines below a support level. When this happens, technical analysts believe the price of the stock
will continue on its course

Answer 54

A breakout above the resistance level is considered a bullish signal. To profit from this, investors may enter a buy stop order slightly above the resistance level. As the stock’s price increases above resistance, the order will be executed and investors will profit as the stock continues to increase in value. Another alternative is for investors to purchase call options on the stock once the breakout has occurred.

A breakout below the support level is a bearish signal. To profit from this, investors may enter a sell
stop order slightly below the support level. As the stock’s price decreases below support, the order
will be executed (essentially a short sale) and investors will profit as the stock continues to decrease in
value. Another approach is to purchase put options on the stock.

Question 55

is a chart pattern used by technical analysts that indicates that a stock has
formed a bottom in its trading cycle and is ready to rise

Answer 55

A saucer

The bottom of the saucer pattern is a bullish
indicator for the stock.

The reverse of the saucer pattern is the inverse saucer, where the stock forms a top in its pattern and is
expected to fall. Following the logic used in the saucer, the reverse is a bearish indicator.

Question 56

The _ Theory states that security analysis doesn’t produce investment recommendations that will allow investors to consistently outperform a randomly selected portfolio. Therefore, a professionally managed portfolio will perform just as well as a portfolio that’s selected in a non-discriminatory fashion (e.g., throwing darts at a newspaper listing of stock prices).

The theory also states that stock prices represent all of the available information regarding a company’s performance. Essentially, the theory suggests that it’s futile to try to identify undervalued securities through the use of either fundamental or technical analysis

Answer 56

The Random Walk (Efficient Market) Theory

Question 57

Assume the following:

S&P 500 has an annual return of 8%.

Stock A has an annual return of 12% and a beta of 1.5.

Stock B has an annual return of 10% and a beta of 0.8.

Beta:

Stock A’s beta of 1.5 implies it’s 50% more volatile than the market. If the market goes up by 8%, we can expect Stock A to go up by approximately 12% (8% * 1.5).

Stock B’s beta of 0.8 indicates it’s 20% less volatile than the market. If the market goes up by 8%, we can expect Stock B to go up by approximately 6.4% (8% * 0.8).

Answer 57

Alpha: To calculate alpha, we first need the risk-free rate (the return on a risk-free investment, such as a U.S. Treasury bond). Assume the risk-free rate is 2%.

Now we’ll use the Capital Asset Pricing Model (CAPM) formula to find the expected return for each stock:

Expected Return = Risk-free Rate + Beta * (Market Return - Risk-free Rate)

Stock A’s expected return: 2% + 1.5 * (8% - 2%) = 11%

Stock B’s expected return: 2% + 0.8 * (8% - 2%) = 6.8%

Finally, calculate alpha by subtracting the expected return from the actual return:

Stock A’s alpha: 12% (actual return) - 11% (expected return) = 1%. This indicates Stock A outperformed the market on a risk-adjusted basis.

Stock B’s alpha: 10% (actual return) - 6.8% (expected return) = 3.2%. This shows that Stock B also outperformed the market on a risk-adjusted basis, and to a greater extent than Stock A.

In summary, beta measures a stock’s volatility relative to the market, while alpha measures its risk-adjusted performance. In this example, Stock A has a higher beta and lower alpha than Stock B, indicating that it’s more volatile but generated less excess return compared to its risk level.

Question 58

True or False. The higher the Beta, the higher the risk implied.

Answer 58

True.

Remember. A 1.5 beta means the stock does beta if the market is positive. - say the S&P 500 is up 10%.

Then the stock is 15% higher.

But visa-versa if the Beta is lower.
Say 0.5%. This means the stock earns less when compared to the market up by 10%. But also, has less risk. Because if the market is down 10%.

The higher beta is down 1.5 but the lower beta is only down 0.5 when comparing both to a market that’s down 10%

Question 59

True or False. The higher the Beta, the higher the risk implied.

Answer 59

True.

Remember. A 1.5 beta means the stock does beta if the market is positive. - say the S&P 500 is up 10%.

Then the stock is 15% higher.

But visa-versa if the Beta is lower.
Say 0.5%. This means the stock earns less when compared to the market up by 10%. But also, has less risk. Because if the market is down 10%.

The higher beta is down 1.5 but the lower beta is only down 0.5 when comparing both to a market that’s down 10%

Question 60

Modern portfolio Theory

Answer 60

Investors want the highest return possible given a specific level of risk

This Theory believes investors are risk-averse

Question 61

is a concept in modern portfolio theory (MPT),

represents a set of optimal portfolios that offer the highest expected return for a given level of risk or the lowest risk for a given level of expected return. In other words, the ______ illustrates the best possible risk-return trade-offs for investors.

Answer 61

Efficient frontier

Question 62

The logic behind this theory of thought in asset allocation is based on the idea of diversification, which aims to reduce the overall risk of a portfolio by investing in assets that exhibit low or negative correlations with each other. Diversification takes advantage of the fact that asset classes often respond differently to various market conditions or economic events, thereby reducing the impact of a downturn in a specific asset class on the entire portfolio.

When asset classes exhibit a high degree of positive correlation, they tend to move together in the same direction. In such cases, the benefits of diversification are limited, as a decline in one asset class

Answer 62

Note